Stock Market Volatility Is Back: How Should Long-Term Investors React?

Happy New Year! To say that 2018 was a challenging year for investors would be an understatement. Without question, it was the most volatile year since the 2008-2009 financial crisis. During the fourth quarter, global stock markets collectively struggled, giving back gains made earlier in the year. U.S. stocks experienced one of the most volatile Decembers on record, with the S&P 500 Index moving more than 1% (up or down) ten times during the month. Diversification across equity asset classes yielded little relief with developed foreign, emerging markets, and real estate securities all in the red for the year. One safe haven from market volatility was U.S. government bonds, which gained just under 1%, even as the Federal Reserve continued its tightening policy and prepared to let the economy stand on its own.

Asset class returns for the quarter and full calendar year were as follows:

Index

Asset Class

Fourth

Quarter 2018

Full Year

2018

Barclays U.S. Govt./Credit—Int.

Fixed Income

1.65%

0.88%

S&P 500

Large U.S. Stock

-13.52%

-4.38%

Russell 2000

Small U.S. Stock

-20.20%

-11.01%

MSCI ACWI ex-USA

Foreign Stock

-11.46%

-14.20%

S&P Global REIT

Real Estate Securities

-5.79%

-5.90%

What caused the sudden bout of market volatility? What is next for the economy and the financial markets, and how should investors position themselves? While we remain optimistic in the long term, we acknowledge ever-present uncertainties impacting the market in the short term: ongoing political division and the U.S. government partial shutdown, continued geopolitical tensions (i.e., China trade issues, North Korea hostility, pullout of U.S. and allied troops from Syria), Brexit, and increased calls for regulation of tech juggernauts such as Facebook, Google, and Amazon. In short, the market may be concerned that some combination of the above issues may cause the economy to falter.

In the financial markets, a laundry list of such concerns is, for the most part, status quo. However, there are numerous bright spots that point to a more optimistic view. While the stock market stumbled in the final months of the year, the economy overall remains fundamentally sound: historically low unemployment (3.9% as of January 4, 2019), strong corporate profits, relatively low interest rates, and valuation measures, such as the forward price/earnings ratio, that are attractive by historical measures. Most economists still believe the likelihood of a recession in 2019 is low, and the economy and the stock market do not always move in lockstep.

Even though the financial markets are hovering in correction territory (down 16% from a recent high), it is important to note that stocks historically have shown great resilience in recovering from downturns. Patient investors may remember previous bouts of volatility during this decade-long bull market and the swift recoveries that followed (returns are for the S&P 500 Index): summer to fall of 2011 which saw a 20% drop between May and August before stocks rallied back to positive territory by year-end; the summer of 2015 which experienced a 10% decline in just over a month before swiftly recovering; and the first six weeks of 2016 when the market slid more than 10% before ending up nearly 12% for the year. As we saw in late 2018, the time periods shortly after market downturns can also provide crucial gains. The largest ever one-day point gain in the Dow Jones Industrials Average index (up 1,086 points or 5%) occurred the day after Christmas, just one trading day after falling nearly 3% on Christmas Eve.

Corrections and volatility can certainly be scary, but they are a natural part of the stock market. Investors will endure numerous market downturns during their lifetimes. Nobody can consistently predict the direction of the market in the near-term and trying to do so typically results in missed gains and ill-timed decisions. Market corrections are quite common, and most corrections do not turn into extended down periods (although some ultimately become bear markets). As illustrated in the graph below, the broad U.S. stock market (measured by the Russell 3000 Index) has averaged about one correction each year from 1979 to 2017, while still achieving a positive total return in 33 of those 39 years.

Source: Dimensional Fund Advisors, Russell 3000 Index depicted.

The single most important task for investors is to maintain a disciplined approach to portfolio management. The danger typically is not a market correction, rather how you react to it. Consequently, we have been rebalancing portfolios to their asset allocation targets, which, for the most part, means selling bonds and buying stocks at lower prices. For most people, this does not feel particularly good, but historically, it has proven to be the right approach. We also spent much of the fourth quarter aggressively harvesting losses in taxable accounts. Carrying these losses forward to future years will ensure that many clients pay less in capital gains taxes, increasing their after-tax rate-of-return. The recent decrease in portfolio values should cause all of us to reassess our saving and spending patterns. As we have suggested for many years, most retirees should not plan on spending more than four percent of their investment portfolio each year to successfully weather down years in the stock market. Recent volatility may lead you to reassess your risk tolerance and asset allocation. While this is generally a healthy exercise, we would caution you not to let emotions lead to hasty decisions, especially if your financial goals have not changed.

We thank our clients and fellow business professionals for their continued trust and support. Please contact our team with any questions or concerns regarding your finances.